Today we are going to take a look at how a Consultant thinks about problem solving. After this exercise, my goal is that you understand that having a global perspective of the world is crucial when trying to become a good investor. Also, I hope that you follow this progress when evaluating companies:
- Evaluate the general market.
- Evaluate the isolated stock in the market.
We are going to go through a real case that I had when I participated in a workshop with a very famous american consulting firm.
A family driven shipping company that´s been very profitable for more than 10 years suddenly starts to lose money. The owner of the firm can´t really see why this is happening, so you are hired to solve this puzzle. Luckely, a guy called Stockles will provide you with some guidance so that the job becomes a bit easier. As a quick tips he says that the market consist of three players, and you are one of them.
Problem solving as a Consultant:
At the start you will probably be thinking a lot of thoughts at the same time. You know that the problem is that you have a firm that suddenly started to lose money, but that can be for so many reasons. So, you ask Stockles for some guidance, and as the kind guy that Stockles is tells you that you need to solve the problem in a structural manner. That always helps. He tells you to first look at the market as whole before isolating your company.
So, you ask yourself. What is a market? You know that a market consist of a buyer and seller. You also know that the price is important because it will make the buyers and sellers behave differently. So you ask Stockles if something has happened to the price in the market of our company? Stockles says no.
Okay. So no price change. Then, if you lose money and the price hasn´t changed, it has to be the volume?! Right? Again, Stockles shakes his head. Strange you think. So basically, nothing has happened in the market, but still my firm is losing money. This will turn in to quite the puzzle.
The Company – Variable and Fixed costs
The natural thing now is to move on the company that you are helping. Here you know that cost is important for a firm, and you know that a firm can have variable costs aswell as fixed costs. Since this is a shipping company, maybe the quantity of oil as a fuel has increased ? Workers are demanding more pay? Maybe the rent of harbor parking has increased? After asking Stockles many questions on both variable costs and fixed costs, he tells you that neither is right. The costs for the company has not increased nor decreased.
The Company – Profits
This is getting hard. No price change. No volume change and now cost change. Still the company is losing money. However, you know that you haven´t asked about profit, which can be devided in revenue and costs. You ask Stockles if profit is the right thing to ask for, and Stockles eyes starts to shine of joy. Boom! We are getting closer.
You know that there are several important things to talk about when talking about profitability:
Gross Margin, Operating Margin, Profit Margin, FCF Margin, EBITDA Margin and so on. Unfortunately, Stockles says that you need to hurry now, so he gives you each companies income statement. You do some calculations and figure out that company C has lower margins, and they lose a lot of money, so it can´t be them anyways. He also tells you that company B has lower prices on the product than you. However, Stockles gives you this paper (income statement)
Okay. Let´s take a look here. WTF!!!! You have higher EBIDTA than company B, and you still lose money. Stockles puts a hand on your shoulders and tells you to breathe and think harder. So you do. You know that EBITDA means Earnings Before Interest, Taxes and depreciation and Amortization. You figure out that the interest has to be the same for both companies (Stockles confirms).
Then you think about the depreciation and amortization. This is basically how much an object loses it´s value over time. Think about a car. As the years pass, the car becomes less and less valuable, this is the same. However, you can´t understand that the ships are so different that the value-loss should make up for the change (you check this and Stockles says you are right).
Taxes might turn everything upside down
So, the only thing is Taxes. Remember, you started out with a company where neither any market change caused the total revenue to decline, and neither any cost problems within the company. At first you say to Stockles that you know taxes differ, but they can´t differ so much. Most companies pay around the same taxes so this can´t be the reason, but then you see the light. You ask: Stockles, where is this other company from? Stockles answers it´s from China.
Different tax system
Awesome. This is the answer, and the whole point behind this weird blog post about consulting and taxes:
Companies that operate in the same industry can have very different terms regarding taxes. Even though costs are the same, prices and even volumes stays the same, one company can take profit from another just because a country (like China) has a very favourable tax system for chinese shipping companies. No, it can´t last for ever, and no, most of the time this “boost” goes away once the firm has been in the market for a while, but it can provide some negative effects in the market in the short term. It also makes it possible for some companies to have a lower selling price on it´s product, and therefore generating lower profits than it´s competitors (without respect to taxes).
The conclusion in this real case was that our company bought the chinese company and thereby killed the opponent, and both companies where happy (Finding out if this was the right choice was the hard part about the case). The chinese company was sold at a high price, and our company could keep going like it had done before (I had to neglect important parts of this case, but hopefully I made some kind of point). Think global, and when trying to analyse a company, first analyse the market before jumping into the stock. This way, you will get a broader understanding and be able to stay calm and patient.
Thanks for reading! I hope that you liked the post. If you did, please comment. I´m keen on writing a blog post about a private equity case, but I need to know if this article had any value to you. Also, I appreciate if you click on the link beneath or click on one of my ads so that the expenses of this blog gets taken care for.